Company Overview: Challenger Limited (ASX: CGF) is a multi-faceted financial services organisation, with core businesses in annuities, funds management and administration platforms. The principal activities of the company are divided into two segments- Life and Fund Management. The Life segment provides annuities and retirement income products whereas fund management segment focuses on retirement savings phase of Australia’s superannuation system. Both operating segments are responsible for appropriate processes and provide necessary resources to meet managerial and legal requirements.  


CGF Details
 
Strong Capital Position and Record Low Cost to Income Ratio: Challenger Limited (ASX: CGF) is a multi-faceted financial services organisation with core businesses in annuities, funds management and administration platforms. The company has two operating segments -Life and Fund Management. As on 9 March 2020, the market capitalisation of the company stood at ~$5.06 billion. In the Annual General Meeting 2019, the top management stated that the company has maintained a strong capital position and is confident for its long-term growth.

Despite the difficult operating environment in FY19, the company demonstrated efficient operations and achieved record low cost to income ratio of 32.6% with expenses down by $1 million to $267 million. CGF made decent progress during the year and has proven to be resilient, reflecting that the company has the right strategy to deliver long term growth. Against the challenging backdrop, group assets under management were up by $627 million on the prior year to $81.8 billion, and normalised net profit before tax increased slightly to $548 million. During FY19, the company maintained superior investment performance, with 93% of the funds outperforming the benchmark over the span of 5 years. During FY19, total life sales of the company stood at $4.6 billion. These were impacted by lower Australian interest rates relative to US rates, leading to more demand by Japanese customers for US dollar annuity products, at the expense of demand for Australian dollar denominated products. The company has expanded its product offerings by adding new boutiques and investment strategies for existing managers. The strong capital position and confidence in long term growth enabled the Board to declare a full-year fully franked dividend of 35.5 cents per share. Over the period of FY15 to FY19, the company witnessed a CAGR (Compound Annual Growth Rate) of 8.87% in total revenue and a CAGR of 8.67% in gross profit.

The company has recently declared its interim results for the period ended 31 December 2019 wherein it laid down strong foundations to drive growth. During 1H20, the company also maintained superior investment performance which helped in attracting strong net flows. During the half year, the company reinsured US dollar annuities and expanded institutional relationships with several other initiatives to diversify its distribution channels and reduce the reliance on Australian retail financial advisers.

Challenger is well-positioned with strong product offerings, positive retirement market demographics and highly efficient operations. The company is investing in distribution, product and marketing growth initiatives and is focused on building additional customer demand, increasing the allocation made to annuities through financial advice and broadening distribution and institutional partnerships.


Normalised ROE and Group’s Assets under Management (Source: Company Reports)

Earnings Momentum from Strong Net Inflows and FUM Growth in 1HFY20: The company has recently released its results for the half year ended 31 December 2019 wherein it reported an increase of 10.2% in assets under management to $86.4 million and a growth of 3.2% in normalised profit before tax to $278.6 million. During the half year, CGF increased the use of secure retirement income streams and reported an increase of 15% in total life sales to $3.1 billion. Challenger’s annuity sales mix continues to evolve towards long-term products with new business tenor over nine years. These are expected to embed more value for shareholders with enhanced ROE. The company’s confidence in future growth enabled them to declare fully franked interim dividend of 17.5 cents per share, which is to be paid on 24 March 2020. 

The company’s funds management is also expanding its presence in Japan in order to support the MS&AD strategic relationship. This progress highlights the resilience of the business. CGF has applied consistency in asset allocation to minimise the unwanted risks such as interest rate, currency and inflation risks. During the 1H20, Fidante Partners’ flows stood at $1.9 billion compared to a net outflow of $1.0 billion in the pcp. These were mainly due to strong flows into both fixed income and equity boutiques. 


Net Flows and Average FUM (Source: Company Reports)

Possible Key Risks and its Management: Challenger Limited recognises a range of risks which are applicable to participants in the financial services industry. These risks include funding and liquidity risk, investment and pricing risk, counterparty risk, licence and regulatory risk, cyber and information security risk and many others. The company invests in assets with long-term cash flows to match the annuity payments. This means that the company must consider the risk of climate change within its risk management framework and work to ensure that this risk is mitigated. The Board is setting appropriate risk appetite for the business and is ensuring that it is able to manage and control the various risks the business is exposed to. The management of these risks will help the company to build long-term shareholders' value.

Future Expectations and Growth Opportunities: The company has started the year well with growth in assets under management driven by strong flows across the business and positive investment markets. CGF is prioritising to improve advisor experience and is focused on strengthening relationships with profit-for-member funds. It is also aiming to maintain financial discipline and strong capital position in the coming years and is expecting FY20 normalised net profit before tax to be in the range of $500 million to $550 million. The company is also targeting cost to income ratio between 30-34% and is likely to pay full year dividends of 35.5 cents per share. Challenger Limited is targeting a pre-tax normalised RoE of RBA cash rate plus 14%.

CGF has a clear strategy to provide its customers with financial security. In FY20, the company will invest up to $15 million across a range of initiatives to drive long-term annuity sales growth. The life management segment of the company has a strong reputation and is educating its customers in order to increase consumer understanding of annuities and build additional customer bottom-up demand. The funds’ management segment is also expanding its presence in Japan and is expected to continue to benefit from the overall growth in Australia’s superannuation system and expansion into international funds management and pension markets.

Details of Top 10 Shareholders: The following table provides an overview of the top 10 shareholders of Challenger Limited. Caledonia (Private) Investments Pty Limited is the largest shareholder in the company, with a percentage holding of 16.17%. 


Top 10 Shareholders (Source: Thomson Reuters)

Increased Profitability and Higher Returns to Shareholders: During 1H20, gross margin of the company witnessed an increase on the previous year and stood at 91.1%, up from 87.6% in 1H19. In the same time span, EBITDA margin went up to 35.8% from 13% in 1H19. During 1H20, net margin of the company stood at 18.2%, higher than the industry median of 17.3%. This indicates that the company is managing its costs well and is able to convert its revenue into profits. In the same time period, Return on Equity was 6%, slightly higher than the industry median of 5.8%. This indicates that the company is well deploying the capital of its shareholders and is capable of generating profits internally. During 1H20, Assets/Equity ratio of the company stood at 7.55x, lower than the industry median of 8.78x and Debt/Equity ratio was 1.90x as compared to the industry median of 2.33x. This indicates that the business is financed with a larger proportion of investor funding and a small amount of debt, resulting in a financially stable balance sheet.


Key Margins (Source: Thomson Reuters)


Key Valuation Metrics (Source: Thomson Reuters)
 
Valuation Methodologies
Method 1: Price to Earnings Multiple Based Relative Valuation

Price to Earnings Multiple Based Approach (Source: Thomson Reuters)

Method 2: Price to Book Value Multiple Based Relative Valuation

Price to Book Value Multiple Based Approach (Source: Thomson Reuters)

Note: All the forecasted figures are taken from Thomson Reuters, NTM: Next Twelve Months

Stock Recommendation: As per ASX, the stock of CGF gave a return of 18.82% in the past six months and a return of 4.95% in the past three months. The stock is also trading close to its 52-week low level of $6.220, proffering a decent opportunity for accumulation. The company has proven to be resilient despite the challenges in the operating environment and has the right strategy to deliver long term growth. The strong capital position with a leading brand and highly engaged team show that the company is well positioned to capture opportunities. Challenger Investment Partners has a track record in asset origination, and a high-quality life investment portfolio is expected to provide reliable income in the coming years. Considering the returns, trading levels, strong operational performance and decent growth opportunities, we have valued the stock using two relative valuation methods i.e., Price to Earnings multiple and Price to Book value multiple. We have arrived at a target price with an upside of lower double-digit (in percentage terms). For the said purposes, we have considered AMP Ltd (ASX: AMP), Suncorp Group Ltd (ASX: SUN) etc., as peers. Hence, we recommend a “Buy” rating on the stock at the current market price of $7.280, down by 11.971% on 9^th March 2020 while the S&P/ASX 200 index plunged by 7.9%.  

 
CGF Daily Technical Chart (Source: Thomson Reuters)

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